Business has its own vocabulary and learning to speak it fluently can really feel like learning another language. There’s a lot that goes into interpreting finances especially. It’s important for small business owners to have a frame of reference when it comes to breaking down some of the key finance and business terms to know.
To help you brush up on your studies and get comfortable talking the talk (so to speak), here’s a quick list of financial terms that you’re likely to encounter. Beyond memorizing definitions, make sure you’re also getting familiar with how these terms fit into the general scope of business accounting. What do they mean in context? And, how can you leverage your understanding of these terms to succeed in business?
- Adjusted gross income. You’ll run into this term around tax time. It’s a representation of your total gross income, minus specific deductions. The lower your adjusted gross income, the less you’ll owe to Uncle Sam. It typically includes all earned wages, dividends, capital gains, retirement distributions, and other forms of income, minus things like retirement fund contributions, student loan interest, alimony, and more.
- Annual percentage rate. This is the total yearly amount that’s charged to borrowers or paid to investors based on a specified sum. It represents the total cost of a loan over the course of a year—or the total amount of income a lender can expect to receive over that same term. It’s commonly abbreviated as APR and doesn’t include compounded interest, whereas annual percentage yield (APY) does.
- Asset. An asset is anything that’s bought and owned that will generate future value. Some assets create value through appreciation: they become worth more over time. Other assets are revenue-generating, which means they have the capacity to create wealth through their function. The key takeaway when referring to assets is their ability to generate positive economic value. The opposite of an asset is a liability: something that creates negative economic value or sacrifice to maintain.
- Balance sheet. A business’ balance sheet lists its assets and liabilities, alongside any shareholder equity. It’s one of the “big three” financial statements and can quickly provide a snapshot of the business’ health. As the name implies, assets must equal liabilities plus equity for the report to be accurate. It’s used to contextualize the company’s income and cash flow statements.
- Bankruptcy. Bankruptcy is a legal term that defines the state of a business that’s no longer able to fulfill its debts. There are different classifications of bankruptcy, but the general theme is that the company is insolvent. Bankruptcy can end in liquidation of the company’s assets or when the company reaches solvency through a restructuring of its assets.
- Bonds. Bonds are fixed-income debt instruments made up of a face (par) value and an interest rate. The bondholder pays the par value to acquire the bond, then receives regular interest payments comparable to the interest rate. At the end of the bond’s term, the bondholder receives the par value of the bond back. Companies often issue bonds as a form of debt financing.
- Bootstrapping. This is the practice of funding a startup using your own money or through small donations. It can also apply to using existing assets and materials to get a business up and running. Bootstrapping is commonly associated with a sweaty startup. A famous example of bootstrapping is Microsoft, which was founded by Bill Gates and Paul Allen in a garage in Albuquerque.
- Business credit score. Your business’ credit score is a representation of your risk profile as a borrower. It depicts the financial health of your business on a scale from 0-100. The higher your credit score, the more likely you are to be approved for loans and lines of credit. Most lenders look for a minimum credit score of 75 when considering a business for an extension of capital.
- Business plan. A business plan is the fundamental working document that outlines a business and its operational strategy. A good business plan contains a description of the business, its goals, its strategy, an assessment of the market and competitors, financial information, and other insights relevant to the business. It’s every business’ most crucial governing document.
- Capital gain/loss. A capital gain or loss is the amount received or lost from the appreciation or depreciation of an asset. For example, if you buy a stock at $100 and sell it for $200, you have a capital gain of $100. If, instead, you lose $20, you have a capital loss of $20. The IRS counts capital gains as a form of income and capital losses can offset those gains.
- Cash flow. Cash flow is the momentum of money moving into and out of a business based on credit and debit actions. Sales revenues and other income represent cash inflows, while expenses and purchases represent outflows. Businesses that are cash flow positive will have more money flowing into the business than out of it.
- Cash flow statement. A cash flow statement monitors when money flows into and out of a business and where it’s going. Accountants often use cash flow statements to assess the bottlenecks in the financial health of the business. The cash flow statement is often paired with the balance sheet to show how changes in cash and cash equivalents affect the business’ financial health.
- Cost basis. The cost basis is the original price paid for an asset. This is an important financial term to know because assets change in value. When the time comes to sell an asset or depreciate it from the balance sheet, capital gains and losses are derived based on the original cost basis of the asset in question.
- Credit limit. A business’ credit limit is the amount of borrowed capital it has access to through a specific line of credit. You’ll find credit limits on credit cards, as well as revolving lines of credit. Credit limits can increase or decrease pending changes in a business’ credit score or creditworthiness.
- Expenses. Anything a business spends money on is considered an expense. In business bookkeeping, there are a variety of different expense accounts to categorize a business’ different expenditures, including insurance expense, interest expense, rent expense, salaries and wages, utilities expense, and more. Expense accounts are one of the five core types of bookkeeping accounts.
- Fixed assets. Fixed assets are those that stay on a business’ books for multiple periods. They tend to include revenue-generating assets such as vehicles, machinery, equipment, buildings, and other so-called capital assets. Fixed assets are generally subject to depreciation.
- Fixed interest rate. A fixed interest rate is an interest rate that doesn’t change throughout the term of a loan period. For instance, if you purchase a vehicle and the five-year loan comes with a fixed interest rate of 5%, you can expect to pay 5% interest monthly for 60 months. This is in contrast to a variable interest rate, which will change as the prime interest rate changes.
- Income statement. Another of the “big three” financial statements, an income statement depicts a business’ financial performance over a period. Also called a profit and loss statement, it shows cash flow by comparing income vs. expenses. This document also shows how the company uses profits: if they’re paid out to stakeholders or reinvested in the company as part of a growth strategy.
- Interest rate. An interest rate is the agreed-upon cost of borrowing money as a percentage. For example, if you borrow $100 at a 3% interest rate, you can expect to pay $3—in addition to repaying the $100 principal balance. On the flip side, the interest rate a lender charges is how much they’ll earn from the transaction. Interest rates can be fixed or variable over the term of a loan.
- Liability. Liabilities represent economic sacrifice on behalf of a business. Typically, this means either the business owes money or that an investment has depreciated in value below its cost basis, incurring a capital loss. Liabilities are the direct offset to assets, which generate positive economic value.
- Line of credit. A line of credit is an extension of capital offered by a financial institution to a business. The business can borrow money from the line of credit at-will, paying it back regularly over time. The business can use this ready access to capital to fund everything from asset purchases to expansions and even to cover operational expenses. Lines of credit are typically subject to variable interest rates.
- Liquidity. Liquidity represents access to capital or the readiness by which an asset can become cash. Cash is the most liquid asset, since it’s easily exchanged for any other asset. Property and equipment are examples of more illiquid assets, since they’re not easily exchanged for cash quickly.
- Net profit. Net profit is the sum remaining after deducting expenses and cost of goods sold (COGS) from gross profit. The simplest way to think about net profit is as bottom-line profit: the amount a business actually banks at the culmination of its operational cycle.
- Net worth. The net worth of a business is defined as the sum of all assets minus all liabilities. For example, if your business has $1 million in assets and $500k in liabilities on its balance sheet, its total net worth is $500k. Net worth isn’t indicative of liquidity and often, the majority of a business’ wealth will be tied up in its assets.
- Principal. In accounting, the principal is the original amount of money borrowed. It doesn’t include any current or unpaid interest associated with the cost of borrowing. For example, if you borrow $100 at 3% interest, you’ll owe $3 against the principal balance of $100 at the end of the loan’s term.
These 25 business terms to know are just a sampling of the many important accounting terms small business owners need to familiarize themselves with. The good news is that these core finance terms are some of the most important, and will pave a better understanding of larger concepts. Keep them in mind as you set up your business bank accounts and focus on proper bookkeeping.